This made it a daunting challenge the other day, when the Program Director for the Bellevue (Nebraska) Kiwanis Club asked me to talk to his group about the current state of the economy. Despite the many often outrageous examples of excessive greed and even criminality, the current debacle began with good intentions: provide opportunities for homeownership to a segment of the population that was historically left out.

New credit rating systems had to be developed to take into consideration the fact that some immigrant groups prefer to live in extended families (multiple generations in one household). The individual income of any one may not qualify for a loan, but they would all be paying the mortgage. Yet, their family patterns meant assets are only held by the male head of household. That’s just one example, and there are many more. It’s just that banks and others came to realize that the existing systems were excluding people who would actually be very good borrowers. The original “subprime” borrowers were like the original “junk bond” companies – they didn’t fit the mold of a model credit customer. But among them were MCI and Turner Broadcasting – plus Enron and Worldcom, of course.

Like junk bonds, the new mortgage product came to be abused by borrowers and lenders alike. This was made worse by developments that blurred the line between banks and brokers. Both parties participated in actions that allowed banks to have their in-house brokers sell off their mortgage loans to Wall Street in the form of bonds. This is called “originate and distribute”. The same bank wrote the mortgages, packaged the loans for sale and distributed the bonds to their clients – collecting fees at every stage.

And here’s where greed entered the picture. The demand for these bonds completely outstripped the supply: senior management put pressure on the troops to write more mortgages and sell more bonds. The fees were pouring in from everywhere. The demand was so great that an average of 40% of the trades failed for lack of delivery – broker-dealers were selling more bonds than were issued. Each bond trade, whether or not there was a failure to deliver, resulted in a commission for the buying and selling broker-dealers. They didn’t have to tell the buyers that there was no delivery – the broker-dealers figured they could fix it later. This was the initial breakdown in regulatory oversight.

The next one came when no one was watching over the credit rating agencies. According to a story on PBS (originally aired November 21, 2008), managers at Standard & Poor’s credit rating agency were pressured to give the bonds triple-A ratings in the pursuit of ever higher fees. (We’ve yet to learn all the details of the potential collusion between banks, brokers, rating agencies, etc., but more news is coming out all the time – stay tuned!)

Along the way, it became clear that these investments in mortgage bonds were, in fact, risky – despite their triple-A credit ratings. That’s where the credit default swaps came in – credit default swaps (or CDS) are simply contracts akin to insurance policies. The bond holder pays a small premium up-front and they get all their money back if the bond goes into default which could happen, for example, if the homeowner owing the mortgage in the mortgage bond ends up in foreclosure. This was another idea with good intentions – it made the bonds more popular and sent more money back to the bank for more mortgages.

The way the theory on structured securities was developed, if a bank can sell the mortgages they can use that cash to write more mortgages and so support local communities that need to expand housing opportunities. It should also disperse the risk, spread it around, so that some economic problem in one town, like a factory closing, won’t cause the local bank to go out of business. Losses on local mortgages would be spread out geographically, spread out over a large number of investors and over different types of investors (individuals, companies, pension plans, etc.) so that no one of them should suffer all the damage.

Greed enters the picture again: instead of the CDS derivatives being sold only to the people who owned the bonds and only in a quantity equal to the value of the bonds that were issued, an unlimited number of swaps were sold. This is as if you have a $1 million home and someone sold you $20 million worth of insurance. The temptation to burn down the house was just too much. What you see now is arson. They are burning down “the house” to collect on the insurance. Except if it were your typical insurance it would be regulated and you would have to have “an insurable interest” in hand to buy the policy at all. This insures that there would be no more derivatives issued than there are assets. No, these CDS derivative contracts are completely unregulated and unmonitored.

Sadly there were no video surveillance cameras in place when Wall Street was spreading around the gasoline and striking the match. Yet now we are stuck watching the house – and the economy – burn down.

Susanne Trimbath, Ph.D. is CEO and Chief Economist of STP Advisory Services. Her training in finance and economics began with editing briefing documents for the Economic Research Department of the Federal Reserve Bank of San Francisco. She worked in operations at depository trust and clearing corporations in San Francisco and New York, including Depository Trust Company, a subsidiary of DTCC; formerly, she was a Senior Research Economist studying capital markets at the Milken Institute. Her PhD in economics is from New York University. In addition to teaching economics and finance at New York University and University of Southern California (Marshall School of Business), Trimbath is co-author of Beyond Junk Bonds: Expanding High Yield Markets.

Have enjoyed and appreciated your work for years. Too bad you're so far outside of the main stream. More could use your understanding of the situation, and your viewpoint.

If the tripod holding up the dirty deeds includes Failures to Deliver as one of the legs, why don't we try to get the States to amend their UCC codes to include the ability of the legal profession to go after the brokerage houses, if they fail to settle any trade within the mandatory T+3 settlement period. The States have the power to control the 'transfer' of securities, in spite of the fact that the SEC, and Wall Street, have repeatedly told the States to 'stick it.' The SEC has taken it upon themselves to create 'law', rather than police and report the breaking of it.

The UCC Code revision of 1992 was designed to smooth the interstate transfer of stocks and other similar commodities. The rights of the States’ to regulate the trading of stocks was never usurped. Unsuspecting State leaders mistakenly gave up power to the Fed that it did not deserve, was not entitled to, and never was mandated by our lawmakers.

"It should be clearly understood, that the rule making power granted to (the SEC,) is not the power to make law. Rather, it is the power to adopt regulations to carry into effect the will of Congress as expressed by the statutes. (The SEC) cannot use its authority to expand its own jurisdiction and to invade the jurisdiction of others, particularly where the agency interpretation is in direct conflict with the language of the federal statutes."

The UCC does not allow investor accounts nor securities to be misrepresented after settlement date. If brokers are crediting more securities than they actually have in their possession or control after settlement date as defined on the federal level by SEC rule 15c6-1, they are in violation of the states’ UCC.

I'd very much appreciate it if those with the knowledge would begin to talk about the future, and how we can kick at least one leg out from under the comfy chair these counterfeiting brokerage houses have built for themselves with our money.

I’m impressed, I must say. Seldom do I come across a blog that’s equally educative and interesting, and without a doubt, you've hit the nail on the head. The problem is something too few men and women are speaking intelligently about. I'm very happy I stumbled across this in my hunt for something concerning this.

RVAC: You're trying to close the barn door after the horses are gone. I'm chasing the horses out so they won't die in the fire.

But don't be discouraged by my "it's too late, baby" attitude. By my calculations, you have until 2017 to get it fixed. Otherwise, we'll be right back where we started -- assuming we make it through this conflagration.

Why isn't there a link from your site to the event Naked, Short and Greedy which my company held in Los Angeles in 2006? Keeping me out of the mainstream? By the way, "fail-to-receive" data on settlement failures gets you less than "fail to deliver" date, which is being released: stock lending cannot hide the failure to deliver.

Despite the many often outrageous examples of excessive greed and even criminality, the current debacle began with good intentions: provide opportunities for homeownership to a segment of the population that was historically left out.

I think its a distortion to say that this crisis "began" with good intentions, as if Angelo Mozilo and Stan O'Neal woke up one morning and said "lets make it my mission to help poor people buy homes". It's naive to think that this was more than a pretense to cover the self-serving greed and recklessness that you devote 90% of your article to describing (very well I might add).

I am also highly skeptical of the notion that revised credit policies deigned to accommodate immigrant families played any appreciable role in the crisis. I've never seen any type of evidence to back this up, most likely because it wasn't that big of a problem. What's worse is that those claims give the xenophobes out there the idea that we can blame it all on the poor brown people - an implication I'm sure you don't endorse, but are nevertheless helping to perpetuate.

The good intentions were not, as you clearly point out, those of guys like Mozilo. It was the good intention of policy makers to expand homeownership. Remember the 2002 goal of the Bush adminsitration to increase homeownership among Hispancics by 5%? I'm hoping he didn't do that to make Mozilo rich... I was at Milken Institute in 2002, working along side a group developed to study "Emerging Domestic Markets" and so I watched this scenario play out. They literally worked to re-design credit scoring systems that were out-dated. Now, I doubt that these and similar efforts would have been successful without the support of so many policy makers. Fannie and Freddie poured money into these efforts and into increasing available loans. Hopefully, not to make Mozilo rich. Did it enable him? Definitely. But I'm not ready to say that there was no redeeming quality to the intention.

Far from naive, my point is exactly in agreement with you: the bastardizations came about in the execution. And, you're suspicion is correct -- the evidence that I've seen indicates that rich, white folks were taking subprime mortgages -- a bastardization of a good idea. They took advantage of opportunities developed to help, for example, someone working in a cash-economy that could not document their income -- and instead used that framework to lie about their income.